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1 Chapter 6: Firms and Production Firms’ goal is to maximize their profit. Profit function: π= R – C = P*Q – C(Q) where R is revenue, C is cost, P is price, and Q is quantity Production function: the relationship between the quantities of inputs used and the maximum quantity of output that can be produced. It summarizes the technology of transforming inputs into outputs.e.g.) q = f(L,K) Fixed input vs. variable input

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2 Short-Run: At least one factor of production is fixed For production function: q = f(L,K) Average product of labor (AP) = q/L Marginal product of labor (MP) = △ q/ △ L AP increases when MP exceeds AP and decreases when MP is exceeded by AP.

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4 Diminishing Marginal Returns (or diminishing marginal product) If a firm keeps adding one more unit of input, holding all other inputs and technology constant, the extra output it obtains will become smaller eventually. Why? –Too many workers per machine –Increases the cost of managing labors, etc.

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5 Production Function: Capital (K) is fixed. Only labor (L) is variable. The marginal product of Labor is The second derivative of q w.r.t. L is which is negative: Concave function. Assume that K is fixed at 100. Draw the production function and the marginal product of Labor. Example: A Cobb-Douglas Function

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6 Long-Run: All inputs are variable Firms can vary input mix to achieve the most efficient production. Isoquant: a curve that shows the efficient combinations of labor and capital that can produce a single level of output (similar to indifference curve) Marginal Rate of Technical Substitution (MRTS): –the extra units of one input needed to replace one unit of another input that allows a firm to produce the same level of output –slope of an isoquant (i.e., )

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7 Diminishing marginal rate of technical substitution

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8 Unique Isoquants

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9 MRTS and Marginal Products By definition of isoquant: To see the small change in q, totally differentiate an isoquant: Marginal increase in output from increasing L Change in L Total increase in output from increasing L by dL

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10 Production Function: Capital (K) is not fixed (long-run). The marginal product of Labor is The marginal product of Capital is The marginal rate of technical substitution (MRTS) is Draw the isoquant curve. Example: A Cobb-Douglas Function

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12 Reasons for increasing or decreasing returns to scale -Increasing Returns to Scale (IRS): -A larger plant may allow for greater specializations of inputs. -Decreasing Returns to Scale (DRS): -Management problems may arise when the production scale is increased, e.g., cheating by workers. -Large teams of workers may not function as well as small teams.

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14 For a Cobb-Douglas production function: If we double all inputs, CRS if IRS if DRS if